Legacy Law Blog

Bankruptcy and IRS tax debts are deeply misunderstood topics, often surrounded by confusion and anxiety.

For individuals and businesses who know very little about these issues, it’s important to start with the basics – not all tax debts are wiped out by bankruptcy, and the rules for clearing IRS debts are complex. However, bankruptcy can provide relief, or at least breathing room, for those facing insurmountable tax bills.

Here’s what you need to know, presented in practical terms for the average taxpayer.

What Is Bankruptcy?

Bankruptcy is a legal process that can help people and businesses who are unable to pay their debts get a fresh financial start.

The two most common types of bankruptcy for individuals and smaller businesses are Chapter 7 and Chapter 13. Chapter 7 is often thought of as “liquidation bankruptcy,” where certain assets may be sold to repay creditors. Chapter 13 is a form of reorganization that allows wage earners and some self-employed people to propose a repayment plan that spans three to five years.​

For businesses, Chapter 11 is the common route for larger reorganizations, but small businesses structured as sole proprietorships or partnerships may use Chapters 7 or 13. It’s important to understand that bankruptcy is not an “easy out” or a cure-all for financial troubles, especially regarding tax debts.

IRS Tax Debts: The Basics

If you owe money to the IRS, you’re not alone.

Tax debts include everything from federal income taxes to payroll taxes, self-employment taxes and penalties or interest for late payments. When financial difficulties hit, past-due taxes can feel overwhelming. The IRS offers options outside bankruptcy, such as payment plans or an Offer in Compromise, but if those don’t work or are not available, bankruptcy can be an option of last resort.​

That said, not all IRS debts are the same in the eyes of the bankruptcy court, and this becomes crucial if you’re considering bankruptcy as a solution.

Can Bankruptcy Clear IRS Tax Debts?

The short answer is sometimes, but not always. Certain older income tax debts can be eliminated in bankruptcy proceedings if you meet strict criteria. Other types—like payroll taxes, fraud penalties or trust fund taxes for business owners—usually cannot be discharged and will remain even after bankruptcy.​

The 3-2-240 Rule (or the Five-Part Test)

To help people remember which IRS tax debts might be wiped out in bankruptcy, there’s a rule of thumb called the “3-2-240 Rule.” The following is how the IRS will apply the rule to determine if the tax debt can be discharged in bankruptcy:

• The tax return for the debt must have been due at least three years before your bankruptcy filing (including extensions).
• The tax return must have actually been filed at least two years prior to bankruptcy—returns filed by the IRS on your behalf don’t count.
• The IRS must have assessed the tax debt at least 240 days before bankruptcy. If there was an audit or a dispute, this window is sometimes longer.​

In addition, the debt must be for income taxes (not payroll or fraud-related taxes), and you must not have committed fraud or willfully evaded tax laws.

If you meet these criteria, Chapter 7 (liquidation) bankruptcy may wipe out those tax debts completely. If not, Chapter 13 may still give you a chance to pay them off in manageable installments while freezing IRS collection efforts like wage garnishment or bank levies.​

What If My Tax Debt Doesn’t Qualify?

If your IRS debt is too new, or falls into an excluded category, bankruptcy will not erase it. Even if bankruptcy will not discharge the debt, the process can still help.

Chapter 13 can stop IRS harassment and spread payments over a longer time frame, making the debt more manageable.​

Also, bankruptcy puts an “automatic stay” on most collections, stopping the IRS and other creditors from seizing your bank accounts, garnishing your wages or filing new liens while your bankruptcy case moves forward.​

Special Issues for Businesses

Businesses face additional complications. While some older business income tax debts can be discharged in bankruptcy, most payroll taxes (the money employers are supposed to collect and remit on behalf of employees) cannot.

Failing to pay these taxes can also result in personal liability for business owners under certain IRS rules.​

A business bankruptcy may involve liquidation (ending the company and selling off assets) or reorganization (keeping the business running under a court-approved payment plan). Either way, tax issues must be handled with care, as the IRS becomes a significant “priority” creditor in the process meaning it’s nearly always paid ahead of other creditors.​

Tax Returns and Bankruptcy: What You Need to Know

Filing bankruptcy does not absolve your responsibility to file tax returns. In fact, staying current on all required tax returns is essential if you want bankruptcy protection. Missing or late returns can make it impossible to discharge tax debts and may even cause your case to be thrown out.​

When you file bankruptcy, a separate “bankruptcy estate” may be created for tax purposes, and special returns might need to be filed. Most of the time, though, individuals continue using the same IRS forms (usually Form 1040 for individuals, and Form 1120 for corporations), but they may need to work with their attorney or a bankruptcy trustee to sort out which income and expenses belong to the bankruptcy estate and which remain personal.​

What Bankruptcy Can—and Cannot—do for Tax Debts

Bankruptcy is not a magic eraser. A taxpayer who is considering a bankruptcy filing must carefully consider what, if any, impact the bankruptcy will have on their tax debts.

The following provides a breakdown of what a bankruptcy will and won’t do for taxpayers who have IRS tax debts:

• May clear older, qualified federal or state income tax debts if all the rules are met
• Will not clear payroll taxes or trust fund recovery penalties for businesses
• Stops collection efforts (like garnishments and levies) while your case is in progress​
• May allow repayment over time for debts that can’t be discharged
• Failing to stay current on tax filings or trying to cheat the system (fraud or evasion) ruins your chances of bankruptcy relief for IRS debts.

Navigating bankruptcy and IRS debts is complicated and fraught with pitfalls. If you’re facing serious tax problems, talking to a qualified tax professional or bankruptcy attorney is always recommended. They can evaluate your exact situation, help you understand your best options, and guide you through the steps so you can move forward with confidence and a clear strategy.

Bankruptcy is a tool, not a punishment. It exists to provide honest debtors, including those struggling with IRS tax debts, a second chance. By understanding the basic rules, you can turn financial chaos into a manageable path toward a new beginning.